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Although valuations appear stretched in certain pockets of the US equity market, we see value in specific sectors. In particular, we like the prospects for US banks.
In our view, select large-capitalisation US banks are likely to benefit from a growing US economy, higher interest rates and a less-restrictive regulatory environment. As a result, we think they have room to increase dividends and stock buybacks as earnings improve and capital is freed up.
Favourable Economic Backdrop
At this time, US economic growth appears to be on solid footing, with tailwinds from tax reform as well as some near-term fiscal stimulus. As the US economy continues to grow, we think select banks are likely to see increased loan and capital markets activity.
In addition, we think the upward momentum in US interest rates is likely to lead to higher bank net-interest income growth, and as a result, greater profitability potential. The US Federal Reserve (Fed) has said it plans to continue to raise interest rates as the economy improves. At its March monetary policy meeting, the Fed reaffirmed its projection of three interest-rate hikes in 2018, which would put the federal funds rate at 2.1% by the end of the year. Also, the Fed projected the fed funds rate will rise to 2.9% by the end of 2019.
Improving Regulatory Environment
In the past year, the regulatory backdrop for the US financial sector has improved for the first time since the global financial crisis (GFC) a decade ago. President Donald Trump’s administration has proposed rule changes that would allow banks to hold less capital, based on how much leverage they hold.
US banks have worked to build up their capital ratios since the financial crisis. Now, we think regulators seem generally confident that bank capital ratios are sound. These institutions performed well in government-mandated stress tests last year, which allowed them to return capital to shareholders. We believe they are likely to continue to perform well.
As a result, select banks seem prepared to return an increasing amount of profits to shareholders as they generate higher levels of after-tax cash flows. Based on our analysis, these banks are likely to be able to boost buybacks and raise dividend payouts over the next couple of years. And because of the more favourable stress-test results, it appears more likely that the Fed will allow them to do so.
Investment Implications
We think valuations of select US banks appear attractive relative to the broader market. In our view, these banks have made great strides in becoming more efficient, and they have generated higher levels of capital than required to meet their regulatory requirements. We believe they stand to benefit from a growing economy and a more favourable regulatory environment going forward.
That said, if US economic activity slows and the outlook for interest-rate hikes decreases, our view could change. Although we don’t see a cause for a slowdown at this time, it is possible a trade war could develop and lead to downward revisions in economic growth. So far, trade tensions have led to bouts of market volatility, but have not signalled that the economy won’t be able to continue growing at its current pace.
The comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Convertible securities are subject to the risks of stocks when the underlying stock price is high relative to the conversion price and debt securities when the underlying stock price is low relative to the conversion price. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.
